Wednesday, July 8, 2009

Free-falling into the Grand Depression (1)

"We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand." No, this is not a case of an incompetent flight crew fumbling with the flight controls. It is what John Maynard Keynes wrote in his essay titled "The Great Slump of 1930" published in December of the same year. His observation refers more to economists bungling with the fiscal and monetary controls of the economy.

As plane crashes have sometimes been caused by pilots' errors in the handling of their aircraft in emergencies, economic crises are similarly worsened by economists' faults in their diagnoses of the crises and prescriptions for the recovery.

The failings of the economists can be understood using the recent fatal plane crashes as analogies in unearthing relevant patterns. Both crashes had no survivors; all perished. The first involves a Continental Airlines flight 3407 that went down in Buffalo, New York on February 12, 2009. The second is Air France flight 447 that dived into the Atlantic on May 31, 2009.

In this post we will deal with with the Continental Airlines plane. The aircraft was a new Bombardier Dash 8-Q400. The crash was solely due to the pilot's incompetency. Both the pilot and co-pilot were suffering from sleep-deprived fatigue. To make matters worse, on the landing approach, they were engaged in nonessential conversation, something not allowed under the aviation rules. As a result, they didn't notice that the air speed had dropped exposing the aircraft to a dangerous stall. The control yoke (analogous to the car steering wheel) was shaking, pointing to a stall. The plane's automatic system tried to push the nose down in order to gain air speed and prevent stall. However, probably in panic, the pilot pulled back the control yoke in order to bring the nose back up. But his action worsened the stall, thus dooming the lives of 49 onboard and 1 on the ground.

Many lessons for the current economic crisis can be gleaned from the accident. The crisis was precipitated by the loose monetary policy which was evident from the phenomenal credit growth. The central bankers however were focused on the inflation rate indicator rather than the credit growth indicator to guide their actions. The inflation indicator was not moving because of the excess supply capacity created by the entry of China onto the global economic stage. The boom in commodity and asset (real property) prices didn't translate into high consumer prices except at a very late stage.

The commercial banks' books were also clean as they had been using off balance sheet vehicles to hide the loan growth. Securitisation of the loans was another method that shielded the loans from being reported. The loans appeared on the books of foreign banks and non-bank players: portfolio managers, pension funds, and insurance companies. Like the doomed Continental Airlines plane, the critical indicator was vibrating but the central bankers chose to ignore it, fixing their eyes on the wrong ones instead.

Another useful lesson is the wrong remedy prescribed to cure the ills brought about by the crisis. Just because the plane was stalling shouldn't mean that the pilot must point the nose upwards. The right move would have been to point it lower in order to gain speed and get out of the stall. Similarly, because the crisis was caused by too much money, some economists are recommending cutting spending and constricting money supply. The sure outcome will be an economy in a death spiral, politically bringing down with it a crumbling nation-state. Don't worry about inflation. The money supply is not even stalling, it's collapsing. At this critical juncture, you need plenty of money. Don't even think of inflation; deflation is the killer.

Regardless, printing money and massive government spending provide only a temporary respite. This depression is a foregone conclusion; there's no way out. We have to endure it before the game changer of the next technology wave allows the economy to recover slightly.

Finally, the most important lesson is the incomplete training of most economists. To be really competent, a professional must go through the rigours of crises. Pilots experience them in simulator rides. They have to because hundreds of lives depend on one pilot. In fact, the pilot of the ill-fated Continental Airlines plane was actually not qualified to fly because he had failed 3 simulator tests, known as check rides.

Economists, on the other hand, do not have the luxury of going through the stress tests. Yet they are responsible for the lives of millions of people. Indeed, we are in the midst of being led by those who have, in the words of Keynes, blundered in the control of a delicate machine. The coming economic crash may yet turn out to be very nasty.

Part 2: The Crash of Air France

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